Management Failure Epidemic

January 12, 2011

As I mentioned in the previous blog, the presidential commission attributed the BP gulf oil spill to a “management failure”.  The country seems to be suffering from a management failure epidemic.  Waves of outbreaks recur every few years:  the Savings and Loan crisis (1986 and 1995), the Enron/WorldCom/Global Crossing collapse (2001), and most recently, the banking and mortgage crisis (2007).  All these incidents have a common cause.  Increasingly, top management operates America’s corporations, not in the long term best interests of the shareholders, but in the short term best interest of themselves.

Executives’ compensation comes mainly in the form of stock options and bonuses.  The better the short term performance, the more lucrative the options and the bigger the bonuses.  This leads them to sacrifice the company’s long term health for short term results.  Here are a few important examples.

Management under invests in research and development.  For example, while Japanese automakers were developing fuel efficient vehicles to meet the obvious developing oil shortage, Detroit automakers were still pushing monster SUVs.   Management under invests in its employees.  During the most recent Great Recession, businesses shed jobs at a faster rate than ever before.  That helped them report surprisingly good profits during the recession, but in the long term, it caused them to lose skilled workers and institutional expertise. 

Management takes on too much risk.  The BP disaster is just one example.  The most recent banking crisis was the result of a Byzantine process in which no one seemed to care about the long term.  Real Estate and Mortgage brokers sold people houses that they could ill afford.  Banks underwrote mortgages that they could not and did not intend to keep on their books but sold to investment banks.  Banks converted the mortgages in to high yielding bonds, collateralized debt obligations (CDOs), and sold them to investors who had no expertise in real estate.  Finally, banks and hedge funds set up special corporations called Structured Investment Vehicles (SIVs, pronounced sieves, as in full of holes) to buy the high yielding, but long maturity CDOs.  To finance the CDOs the SIVs borrowed money in the low interest, but short term commercial paper market.  However, that obliged them to borrow frequently, selling some new commercial paper each day to cover the notes coming due that day.  The theory was that they would pocket the difference between the cheep short term commercial paper market rates and the high CDO rates.  However, when the mortgages began to fail no one wanted to buy the SIV’s commercial paper, the end was near.  Management covered the problems for months by cooking the books, but finally the long term arrived and the whole house of cards collapsed. 

What can be done?  Can we rely on government regulation to oversee the drilling of each oil well?  Can government regulation prevent banks from cooking up the next Rube Goldberg scheme to make a quick buck?  It seems unlikely.   Can we rely on management to be high minded and altruistic?  That is contrary to human nature and history. 

A better idea might be checks and balances in America’s corporations.  In government, we feel that dictatorship is a bad idea, but in economics most people feel that dictatorship is essential.  Most corporations are under the dictatorship of the Chairman/CEO and that is what allows management to run the company in their own interests. 

I would argue that the following checks and balances would better align the interests of the CEO and the shareholders.

  • Split the CEO and the Chairmanship so that the same person cannot hold both offices.
  • Make the Chief Financial Officer report directly to the board of directors so that the CEO cannot order the CFO to cook the books.
  • Eliminate golden-parachute, employment contracts that allow the CEO to walk away from the disastrous consequences of his short-term, high-risk decisions without sharing the fate of the shareholders.
  • Eliminate management’s role in nominating members of the board of directors and exclude any nominees with conflicts of interests or ties to the CEO or Chairman.

These reforms are simple, inexpensive, and have an excellent chance of being effective.  What chance is there that they will be enacted into law?  That is an interesting question.  If you answer “yes”, you are probably being naive.   If you answer, “no”, you have put your finger on the real cause of the epidemic.


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